The Double-Edged Sword of Portfolio Concentration

Along with the potential for high return comes high risk

Diversification is a generally accepted principle of sound investing—a portfolio spread out over a variety of market segments and asset classes allows for more predictable returns and less risk. Concentration, on the other hand, takes a decidedly different approach.

It suggests that focusing your portfolio in a handful of industries that historically outperform the market as a whole will maximize returns and allow you to reach your financial goals more quickly. It is sometimes also more manageable than the wider array of components that typically make up a more diversified portfolio (though vehicles like index funds enable much easier diversification and investing).

But it can also pose significant risk. If your portfolio relies heavily on one particular kind of investment and it suddenly goes south, your losses will be far greater than if you had diversified across a wider array of options.

How and why concentration takes center stage

There are several potential reasons why you may have a concentrated portfolio:

  • It’s an intentional investment strategy. You’re confident that you can ride the wave of concentration all the way to its crest and come safely out the other side.
  • Your assets have performed well. Perhaps one type of investment has been on a tear in a bull market, therefore tilting the value of your portfolio in its direction.
  • Your investments are illiquid. Some types of investment vehicles, such as non-traded Real Estate Investment Trusts (REITS), are tough to sell quickly during a downturn. Likewise, other investments, like annuities—will invoke a surrender charge if you try to sell them too early.
  • You own a lot of company stock. It can be tempting to pour a retirement nest egg into an employer’s stock.
  • Your assets are correlated. You may have too many investments in the tech sector, or too many bonds in a particular geographic area.

Given all this, you might think it would be an easy decision to sell a concentrated position, but one factor often stands in the way—taxes. As your investments have grown in value, so too has the tax burden on them. The rate at which this happens depends on how much the value has grown, where you live, what you earn annually, and how long you’ve had the investments. Some will owe nothing in taxes, some as much as 30 percent.

What you can do about it

If you find yourself in this position, no need to push the panic button. There are a number of ways to remedy the situation and keep your portfolio on an even keel in the future.

  • Diversify your portfolio across asset class (stocks, bonds, real estate), your stocks across industries (a healthy balance of retail, biotech, electronics, etc.), and your bonds across type (Treasury, corporate, and municipal). Exchange-traded funds (ETFs), mutual funds, and life-cycle funds can be useful tools to this end. Other strategies can include completion funds, equity collars, exchange fund pooling, and variable prepaid forward contracts.
  • Adjust periodically. Be sure to check in with your fund manager (or yourself, if you manage on your own) regularly to go over your investments and make sure you’re still on track to meet your goals. Your employer may also have resources to help rebalance.
  • Do your homework. Every ETF and mutual fund has a prospectus, which can very quickly show where overlap may occur. Some funds are very finely targeted, and others may hold positions in similar companies.
  • Learn about liquidity. As mentioned above, some types of investments may be more difficult to sell than others on short notice. Be sure to check the offering documents and, when in doubt, consult a financial advisor.

We can help

Concentration risk can be tricky to spot—particularly if your portfolio has a complex array of investments—and having a trusted group of professionals in your corner can provide valuable peace of mind.

Lindberg & Ripple is an independent insurance advisory and investment firm that provides experienced investment consulting, sophisticated wealth management, and innovative insurance solutions for successful families and executives. We’d love to help your family or business achieve their financial objectives, and minimize expense, taxes, and general unease. Contact us today for a free consultation.

The information is obtained from sources that are believed to be reliable but we make no guarantees as to its accuracy. This material is for educational purposes only. Educational material should not be construed as legal or tax advice and is not intended to replace the advice of a qualified attorney, tax advisor and plan provider. By accessing any links above, you will be connected to third party web sites. Please note that Lindberg & Ripple are not responsible for the information, content or product(s) found on third party web sites. Investments in securities involve risks, including the possible loss of principal. When redeemed, shares may be worth more or less than their original value. Diversification does not ensure a profit or protect against loss in a declining market. Securities and Investment Advisory Services Offered Through M Holdings Securities, Inc. A Registered Broker/Dealer and Investment Adviser, Member FINRA/SIPC. Lindberg & Ripple is independently owned and operated. #2804812.1